This ETF Offers High Yield While Keeping Risk in Check

In an environment where trillions of dollars’ worth of assets sport negative yields, investors want reliable sources of income. But reaching for yield is risky business. Investors would be wise not to overreach. Vanguard High Dividend Yield ETF VYM is one of the best options for investing in high-dividend-yielding stocks without taking on too much risk. Broad diversification and market-cap weighting help the fund balance current yield and risk and support the fund’s Morningstar Analyst Rating of Silver.

The fund tracks the FTSE High Dividend Yield Index. This benchmark sorts stocks by their dividend yield and adds names to the portfolio until it captures half of the dividend-paying universe’s market capitalization. This leads to a broad portfolio that diversifies away most stock-specific risk. As of August 2019, it held more than 400 stocks with only 27% of assets in its 10 largest positions.

High-yielding stocks can be risky because they usually pay out an above-average share of their earnings in the form of dividends. That leaves a smaller buffer to preserve dividend payments should earnings fall, making them prone to dividend cuts. But this fund weights its holdings by market capitalization, which tilts it toward relatively larger companies that are more likely to maintain their dividend payments. Its average market capitalization has historically run higher than the Russell 1000 Value Index. Market-cap weighting also cuts back on turnover and the related trading costs.

The fund’s focus on dividend yield means it has a value orientation. It ranked among the better-performing funds in the large-value Morningstar Category over the 10 years through August 2019. But value strategies underperformed the wider U.S. market over the past decade and this strategy was no exception. It lagged the Russell 1000 Index by 1 percentage point annually over the same stretch.

Vanguard charges 0.06% annually for this fund. It is one of the least-expensive dividend income funds in the large-value category, which should translate into strong category-relative performance.

Fundamental View Dividend yield investing has become popular in light of historically low interest rates where investors are searching for income. However, higher-yielding stocks are risky because these companies may be under financial distress and prone to cutting their dividend payments. These companies may pay out a large share of their earnings and have a narrow buffer to cushion these payments if their business deteriorates compared with their lower-yielding counterparts.

This fund mitigates some of its stock-specific risk by diversifying across hundreds of names. It weights holdings by their market capitalization, which emphasizes companies that are relatively larger while keeping turnover in check. Large corporations are more likely to have competitive advantages and should be better equipped to maintain their dividend payments than smaller, higher-yielding stocks. Market-cap weighting also incorporates knowledge of the market and reduces the fund’s exposure to stocks as their prices deteriorate.

Like most dividend-oriented strategies, this fund has a value tilt. Larger and slower-growing firms tend to trade at lower valuations and pay out a larger share of their earnings as dividends than their faster-growing counterparts, which invest aggressively to expand. Both characteristics can lead to higher dividend yields. The fund’s holdings tend to generate higher average returns on invested capital than those in the Russell 1000 Value Index and the category. These attributes are also observed in the fund’s persistent sector tilts. It tends to have greater exposure to the consumer defensive sector and less exposure to financial stocks than the average fund in the category.

This fund earns a Positive Performance Pillar rating based on its strong long-term risk adjusted returns versus the category average. Over the trailing 10 years from August 2009 through July 2019, the fund has outperformed the category average by 2.2% points annualized while exhibiting lower risk. On a risk-adjusted basis, the fund outperformed the large-value category average. Much of this relative outperformance can be attributed to the fund's cost advantage; lower-than-average cash drag; and more favorable stock exposure in sectors such as energy, financial services, industrials, and technology.

Portfolio Construction The fund fully replicates the FTSE High Dividend Yield Index. It effectively diversifies firm-specific risk and promotes low turnover, supporting its Positive Process Pillar rating. This benchmark starts with all the U.S. dividend-paying stocks from the FTSE All-World Index but excludes REITs. FTSE ranks stocks by their 12-month indicated regular dividend yield based on I/B/E/S forecasts. It adds stocks to the index, starting with the highest-yielding names, until the portfolio's cumulative market cap represents half of the selection universe's market cap. To mitigate turnover, constituents may stay in the index as long as they fall in the highest-yielding 55% of the selection universe by market cap. The index adds new stocks once they break into the highest-yielding 45% of the investable universe. It reconstitutes semiannually in March and September.

Fees Vanguard charges a low 0.06% expense ratio for this fund. This fee is a fraction of the 0.85% median levy that the fund's large-value peers carry. It earns a Positive Price Pillar rating. Over the trailing three years through July 2019 the fund lagged its benchmark by an amount comparable to its expense ratio.

Alternatives Gold-rated Vanguard Dividend Appreciation VIG (0.06% fee) prioritizes dividend growth over yield. It holds stocks that have increased their dividend payments in each of the past 10 years and weights them by market cap. This tilts the portfolio toward highly profitable firms with durable competitive advantages, which should hold up better than the market during market downturns. VIG lands in the large-blend category with a yield that is comparable to that of the Russell 1000 Index.

Silver-rated Schwab U.S. Dividend Equity ETF SCHD (0.06% fee) also finds higher-than-average dividend yield but balances the risk of its holdings with a few quality metrics. SCHD targets 100 stocks with high dividend yields, return on equity, cash flow/debt, and five-year dividend-growth rates.

Bronze-rated Invesco S&P 500 High Dividend Low Volatility SPHD (0.30% fee) selects 50 high-yielding stocks from the S&P 500 but seeks to reduce risk by targeting stocks with low volatility. SPHD weights its holdings by their dividend yield, so it may be riskier than VYM.

WisdomTree Large Cap Dividend DLN (0.28% fee) selects the largest 300 dividend-paying stocks and weights them by their expected dividend payments over the next year. This strategy strikes a balance between firm size and yield, supporting its Bronze Analyst Rating.

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